Archive for October 31st, 2008

Emerging Economies facing the heat now

October 31, 2008

A couple of policy initiatives suggest things have  turned tense at emerging economies as well. First 4 emerging economies central banks – S.Korea, Brazil, Mexico and Singapore set up a swap facility with Fed. The facility is for USD 30 billion each and is applicable till 30 April 2009. So after 10 developed economies (with NZ as the latest), emerging economies have set up swap facilities as well (though Both Korea and S’Pore are not strictly emerging).

Second, IMF has set up Short term liquidity facility for emerging economies with strong economic policies that are facing temporary liquidity problems in the global capital markets. Transcript of press conference to launch this facility is here.  Simon Johnson points the amount is not liely to be enough. Rodrik also shares similar views.

Why Iceland collapsed and are there some economies like Iceland’s?

October 31, 2008

I had pointed to the interest rate policy reversal by Iceland Central bank. There is full chaos there. However, the falling of Iceland was not very well known

WIllem Buiter and Anne Sibert have analysed the Iceland problems in this voxeu piece. The article is a summary of a more detailed paper available here. The analysis points that Iceland model was always problematic and bound to fail:

In the first half of 2008, Buiter and Sibert were invited to study Iceland’s financial problems. They identified the “vulnerable quartet” of (1) a small country with (2) a large banking sector, (3) its own currency and (4) limited fiscal capacity – a quartet that meant Iceland’s banking model was not viable. How right they were.

The duo studies the problems but the report was not made public as it was pretty sensitive. As Lehman collapsed, Iceland’s banks foreign assets and exposure was noticed and rest is history. As things are well known now, Buiter et al have released the paper and it has very useful lessons.

Why it fell?

Our April/July paper noted that Iceland had, in a very short period of time, created an internationally active banking sector that was vast relative to the size of its very small economy. Iceland also has its own currency. Our central point was that this ‘business model’ for Iceland was not viable.

The mistakes made

Couple of mistakes were made worsening the crisis

The decision of the government to take a 75 percent equity stake in Glitnir on September 29 risked turning a bank debt crisis into a sovereign debt crisis. Fortunately, Glitnir went into receivership before its shareholders had time to approve the government takeover

Then, on October 7, the Central Bank of Iceland announced a currency peg for the króna without having the reserves to support. It was one of the shortest-lived currency pegs in history. At the time of writing (28 October 2008) there is no functioning foreign exchange market for the Icelandic króna.

In addition, outrageous bullying behaviour by the UK authorities probably precipitated the collapse of Kaupthing – the last Icelandic bank still standing at the time. The official excuse of the British government for its thuggish behaviour was that the Icelandic authorities had informed it that they would not honour Iceland’s deposit guarantees for the UK subsidiaries of its banks. Transcripts of the key conversation on the issue between British and Icelandic authorities suggest that, if the story of Pinocchio is anything to go by, a lot of people in HM Treasury today have noses that are rather longer than they used to be.

I liked the Pinocchio bit :-). Despite the policy mistakes, the fall was pretty clear as the large international banking model was unsustainable at the first place. An excellent analysis and if it had been released earlier, Buiter and Sibert would have joined Nouriel Roubini as Doomsayers.

However, they point similar conditions in other economies as well:

Iceland’s circumstances were extreme, but there are other countries suffering from milder versions of the same fundamental inconsistent – or at least vulnerable – quartet:
(1) A small country with (2) a large, internationally exposed banking sector, (3) its own currency and (4) limited fiscal spare capacity relative to the possible size of the banking sector solvency gap.

Countries that come to mind are:

  • Switzerland
  • Denmark
  • Sweden

and even to some extent the UK, although it is significantly larger than the others and has a minor-league legacy reserve currency.

Ireland, Belgium, the Netherland and Luxembourg possess the advantage of having the euro, a global reserve currency, as their national currency. Illiquidity alone should therefore not become a fatal problem for their banking sectors. But with limited fiscal spare capacity, their ability to address serious fundamental banking sector insolvency issues may well be in doubt.

Incidentally, today’s Eurointelligence points Denmark is thinking of joining the Euro as they can’t have their cake and eat it too. By being a member of EU but not adopting Euro will not work forever.

I was also wondering what would have been the fate of India if Mumbai International Finance Centre reportwas actively taken up by policymakers. The idea behind international finance centre is to provide international finance options to both domestic and international companies from Mumbai. This would have implied Indian banking system would have become more international with times. Now, in this crisis out of the 4 conditions for Iceland, 2 would have been applicable to India as well-  (2) a large, internationally exposed banking sector, (3) its own currency

The other two i.e. (1) A small country  (4) limited fiscal spare capacity relative to the possible size of the banking sector solvency gap – would have depended on the magnitude of the crisis hitting Indian shores. As current experience shows countries that are large and have spare fiscal capacity are facing the brunt as well.

This does not imply not to have an international finance centre in Mumbai but be prepared for such events as well.

Assorted Links

October 31, 2008

1. TTR points western regulation is on trial

2. Mostly Economics also joins MR in support of Felix Salmon

3. WSJ Blog points Recession call is awaited keenly

4. Mankiw points to Roubini’s next prediction- get ready for deflation. Hamilton doesn’t agree

5. Rodrik points to good news for emerging markets but qs still remain

6. FIn Prof points Deutsche Bank in black because of accounting changes

7. Bogle Blog points to NYT profile of the man

8. ALB says we need fin edu more than ever

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